Will America succumb to the same fate as Japan?

As possible financial Armageddon looms in the shape of warring American
politicians, many are asking what happens if the worst - a default by the US
on its debt - is avoided, but the country still loses its prized triple-A
credit rating?

Tokyo offers up a glaring example of what not to do over a downgradePhoto: AP

The scenario is increasingly under discussion. Standard & Poor's, one of the triumvirate of leading credit rating agencies, has warned it could cut its rating on US Treasuries (government bonds) even if the debt ceiling is raised, since politicians may not agree to cut spending as it wants.

Investors are now turning to Japan for lessons as the country has first-hand experience of losing a top-notch rating. Certainly, Tokyo offers up a glaring example of what not to do over a downgrade.

Back in 2002, Takeo Hiranuma, the then economy minister, was the focus of an international row over his reaction to the decision by Moody's Investor Service to put his country's rating on a par with various emerging economies and below Botswana.

"About half of the people of Botswana are AIDS patients and it is outrageous that [Japan's] rating is lower," he fumed. Soon not only did he have faltering growth to deal with, but he also had to make a grovelling apology to AIDS sufferers over his (factually inaccurate) comment.

The drama marked just one of a series of downgrades which followed the move from Moody's to cut Japan's sovereign rating one notch, from Aaa to Aa1, its second highest grade, in November 1998.

Citing long-term risks arising from economic and policy weaknesses, Moody's put an end to the country's hopes to keep its prime credit rating.

The decision had already been anticipated a few weeks earlier when Fitch, the smallest of the top three agencies, downgraded Japan's foreign-denominated debt. Standard & Poor's, the last of the trio, eventually followed suit.

Yet ignoring the indignity of it all, Barry Knapp, an economist at Barclays Capital, thinks the impact was not as bad as it looked. He concludes that it was the "macro fundamentals" - the bright spots and problems in Japan's economy - which drove asset prices, rather than the cut to the country's credit rating.

Admittedly, the reaction to the Moody's downgrade did look alarming. The yields, or returns, on Japanese government bonds rose sharply, suggesting investors demanded greater rewards to shoulder the risks around the debt. But "counter-intuitively", the yen and the Nikkei index rallied.

It turned out that Japan's industrial production had just bottomed out. Moody's had chosen to downgrade Japan "at the end of recession".

Not only that, but it was the autumn of the $4.6bn collapse of hedge fund Long-Term Capital Management. Worried investors' "flight to quality" – such as Japanese bonds – had depressed the yields.

That suggested that yields were already set to rise (in other words, demand for the bonds would fall) as markets regained their appetite for riskier assets. "The sharp move higher in yields had already begun prior to the downgrade and continued as the economy emerged from recession," Mr Knapp summarised.

What does this mean for the US? It will be downgraded but the big picture figures will drive shares, bonds and the dollar, Mr Knapp predicted. "After a brief muted market reaction, the direction of the markets will be highly leveraged to the data with expectations of a [second half of 2011] rebound in economic activity hanging in the balance."

A reassuring view – assuming, of course, that the threat of default is just that.